|
Advanced Strategies for Options -
Diagonal Spreads - Diagonal Bull Spread
In
previous lessons we have written about the various ways to spread
options. We have
already covered vertical and horizontal spreads. The next logical type of spread is the diagonal.
When
an investor uses both different strike prices and/or different
expiration dates to construct a spread it is said to be diagonal. Generally the long side of the spread would expire
later than the short side of the spread.
In
general when a spread is diagonal the investor has a more bearish
outlook. We know this
because in general it is advantageous that the stock not move
significantly ahead of the near term expiration. If the stock falls the long side of the spread will retain
some value because of its longer maturity.
The
major advantage of diagonal spreads is that an investor can
re-establish the position if the short side of the spread expires
worthless. In this
regard the increased cost of buying a longer-term call may be
reduced because calls can be written twice.
Diagonal
Bull Spread
We
know that a vertical bull spread consists of long call at a lower
strike price and a short call at higher strike price, both with
the same expiration date. The
diagonal spread is similar with one important exception. The long call would have a longer-term expiration than the
short call. The
number of calls long and short remains the same.
You
might ask why any one would want to use this strategy. Diagonal spreads are useful when an investor believes a
stock will remain in a narrow range for a certain time frame
before accelerating either higher or lower. The major advantage of this strategy is if the investor is
correct the position can be re-established and the cost of the
longer-term call substantially reduced.
Consider
the following example. Ryan
has been monitoring the shares of Starbucks (SBUX) for several
months. He is aware
the company has scheduled shareholders meeting for March. At that meeting it is widely expected the firm will
announce a corporate restructuring and possible plans for European
expansion. In the
near term Ryan believes the stock could be trapped in a narrow
range. With SBUX
shares trading at $32 Ryan decides to enter a diagonal bull
spread. Ryan buys one
contract of the SBUX July 30 call at $5 per contract and sells one
contract of the SBUX April 35 call at $2 per contract for a net
debit of $3 per contract or $300.
For
the sake of comparison we will also consider a normal bull spread. If Ryan entered this position he may buy one contract of
the SBUX April 30 call for $4 per contract and sell one contract
of the SBUX April 35 call for $2 per contract for a net debit $2
per contract or $200.
Now
let’s run through both examples. We have estimated the value of the options.
|
SBUX
Price at April Exp.
|
Price
of April 30 call
|
Price
of April 35 call
|
Price
of July 30 call
|
Vertical
Bull Spread Profit
|
Diagonal
Bull Spread Profit
|
|
20
|
$0
|
$0
|
$0
|
($200)
|
($300)
|
|
24
|
0
|
0
|
0.50
|
($200)
|
($250)
|
|
27
|
0
|
0
|
1.00
|
($200)
|
($200)
|
|
30
|
0
|
0
|
2.00
|
($200)
|
($100)
|
|
32
|
2.00
|
0
|
3.00
|
$0
|
$0
|
|
35
|
$5.00
|
0
|
5.50
|
$300
|
$250
|
|
40
|
10.00
|
5.00
|
10.00
|
$300
|
$200
|
|
45
|
15.00
|
10.00
|
15.00
|
$300
|
$200
|
As
we can see from the example above the vertical and diagonal
spreads are very similar in profit potential. Both spreads incur their maximum losses if the shares of
SBUX fall substantially ahead of the April expiration. When the shares of SBUX rise above the short call strike
price ($35) each spread works toward its maximum profit potential. As we can see the maximum profit for the vertical spread is
$300 and the maximum profit for the diagonal spread is $250. This point is interesting because should SBUX rally to $35
at the April expiration the July 30 calls should maintain some
time premium. As the
stock rises substantially beyond $35 this time premium shrinks.
You
might think Ryan is better off establishing the straight vertical
spread because the cost is less and the downside risk is also
less. But should SBUX
shares close below $35 at the April expiration there is a good
chance Ryan will have the opportunity to enter a new vertical
spread by selling the July 35 calls. If this occurs the cost of the original long call (July 30
call) would be substantially reduced.
Summary:
1. The diagonal spread is an improvement over the
traditional vertical spread when the stock remains unchanged or
falls modestly ahead of the written call expiration date.
2. The major attraction of diagonal spreads is the
possibility of re-establishing the spread after the written call
expiration date.
ratio
calendar spread 
diagonal bear spread
|
Home > Education > Using Options > Advanced Strategies >
Diagonal Spreads > Diagonal
Bull Spread
